Changes in tax law went into effect on Jan. 1, 2018, with the Tax Cuts and Jobs Act (TCJA). This law significantly affected the tax deduction for interest on a mortgage refinance loan. The rules aren't as generous as they were in 2017, so you might want to bring yourself up to date before you consider refinancing your mortgage.
You can no longer use the funds for anything other than your home. At least, not if you want to claim the tax deduction.
- The rules for deducting interest on a mortgage refinance changed with the Tax Cuts and Jobs Act that went into effect on Jan. 1, 2018.
- You can deduct interest on a loan in excess of your existing mortgage if you use the proceeds to buy, build, or substantially improve your home.
- Borrowers can deduct home mortgage interest on the first $750,000 of indebtedness unless they’re married filing separately.
- You must itemize to claim this tax deduction.
What Mortgages Are Included
The 2018-2025 deduction rules apply to the refinancing of an initial mortgage that was completed after Dec. 15, 2017. Mortgages entered into before this date are grandfathered in.
The TCJA rules regarding refinancing don't apply unless the initial mortgage went into effect on or before that date. Also, the new loan can't exceed the amount of the original mortgage.
The majority of these changes are set to expire at the end of 2025 when the TCJA sunsets unless Congress reauthorizes the Act or renews certain aspects of the law.
How the Money Must Be Used
Whether you are entitled to deduct interest on a loan in excess of your existing mortgage also depends on how the amount of the proceeds and how you use them.
Under the rules for home loans, interest payments can be deducted if you use the loan proceeds to buy, build, or substantially improve your primary home or a second home. The change to the law requires that home equity funds be used only for this purpose in order to be deductible. Previously, the proceeds from the home equity loan could have been used on anything.
Related tax law doesn't allow you to deduct payments of interest on consumer loans when you use the excess amount for any other purpose.
Home Equity Loans vs. Consumer Loans
"Consumer loans" includes using the money to pay down credit card bills, auto loans, medical expenses, and other personal debts such as overdue federal and state income taxes.
Before, most borrowers were able to sidestep these restrictions on deductions for consumer interest thanks to the pre-2018 rules for home equity loans.
Limits on Mortgage Indebtedness
You can deduct home mortgage interest on the first $750,000 of indebtedness. If you're married but filing separate returns, the limit is $375,000, according to the Internal Revenue Service (IRS). A higher limit of $1 million applies if you're deducting mortgage interest from indebtedness that was incurred before Dec. 15, 2017. If married filing separately, that limit is $500,000 for each spouse.
The old rules allowed taxpayers to deduct interest on an additional $100,000 of indebtedness, or $50,000 each for married couples filing separate returns.
There is an overall limit of $750,000, or $375,000 each for married couples filing separately, when refinanced loans are partly home acquisition loans and partly home equity loans.
The collateral for the loan must be the home for which the improvements were made, and the combined debt on the home can no longer exceed its original cost.
Effect of the Alternative Minimum Tax
Yet another rule applies if you pay the alternative minimum tax (AMT). The tricky rules for this tax still allow deductions for interest payments on loans used to buy a home. But they also deny a deduction for interest on home equity loans for first or second homes unless the loan proceeds are used to buy, build, or substantially improve the dwellings.
Itemizing Is Required
There's one more thing to think about: You must itemize in order to claim this tax deduction. This means filing Schedule A with your Form 1040 tax return, detailing each and every tax-deductible dollar you spent all year. You would then claim a deduction for the total.
You might not mind doing a little extra work at tax time if it's going to save you money. But that might not happen because the standard deduction available to taxpayers increased greatly in 2018, also due to the TCJA.
As of 2021, taxpayers are entitled to the following standard deductions:
- $25,100 for married taxpayers filing jointly
- $12,550 for married taxpayers filing separate returns
- $12,550 for single taxpayers
- $18,800 for taxpayers who qualify as head of household
Taxpayers must choose between itemizing or claiming the standard deduction. They can't do both. The total of your itemized deductions must be greater than the amount of the standard deduction you can take. If not, you'd be paying tax on more income than you have to. Both the standard deduction and the total of your itemized deductions subtract from your taxable income.